Many financial planners will suggest that you allocate no more than 10-15% of your investable net worth into a single stock position. That range can allow you to benefit from the potential upside of a growing, successful company, without leaving your assets too vulnerable to a less-desirable outcome if the company underperforms.
If you want to follow that guideline and you receive equity compensation, that means understanding how to strategically liquidate company stock whenever you could potentially exceed that suggested threshold.
That’s a task that can get complicated, and fast. To help you manage it, here’s what you need to know.
Liquidating Company Stock Requires Consideration of Several Variables
The suggested guideline for how much exposure to a particular stock that’s safe to maintain is just that: a guideline. The 10-15% range is not a hard and fast rule, so the first thing to understand is that you don’t have to maintain this all the time with no exceptions.
There may be times when you intentionally hold your shares in hopes that the stock price increases. Other times, holding period requirements, unvested shares, stock price fluctuations, blackout or lockup periods, and other factors may prevent you from having complete control over what percentage of your net worth is exposed to those shares at any given moment.
The second major consideration when thinking about how to strategically liquidate company stock is potential tax impacts. The tax rules that apply will vary depending on whether you have an employee stock purchase plan, non-qualified stock options, incentive stock options, or restricted stock.
For example, you may want to consider questions like:
- Should I recognize ordinary income now, or defer it until later?
- Do I have stock with a basis that is equal to the market value of the stock that I can liquidate with little or no tax consequences?
- Do I have stock at a loss?
- Should I exercise and hold options to take advantage of long-term capital gain rates in the future?
- What is the AMT impact if I exercise and hold my incentive stock options?
There is no single“right” answer to these questions. But it is possible to develop a strategic way to liquidate company stock by considering what type of equity comp you have and what tax considerations apply to your situation based on what you have — and your overall investment goals and objectives.
The Tax Impact of Liquidating Shares of Company Stock You Own Outright
If you don’t receive equity compensation, you can still own company stock by purchasing it on the open market through a brokerage account or other investment account. When you purchase any stock, from your company or otherwise, the price you pay for shares is known as the cost basis. Generally speaking, the tax implications when you sell your shares will be based on the cost basis and the fair market value when you sell.
Before selling out of any positions, you’ll want to consider whether the action will result in a short-term capital gain (or loss) or a long-term capital gain (or loss).
Short-term capital gains (and losses) will be recognized if you sell the shares within one year of purchase, and will be taxed at ordinary income tax rates. You’ll have a long-term capital gain (or loss) if you sell the shares one or more years after the date of purchase.
Long-term capital gains are taxed at different rates than ordinary income. If you have a long-term capital gain or loss, the tax rate can be as low as 0% or as high as 20% (for 2021), but you’ll commonly see these at 15%.
Tax Considerations for Liquidating Company Stock from an ESPP
An employee stock purchase plan (ESPP) is a benefit that allows employees to purchase shares of company stock through convenient payroll deductions. If the plan is a qualified ESPP, you may be able to purchase shares at a discount of up to 15%.
Some plans also allow participants to take advantage of a lookback provision as well. This benefit allows you to purchase shares at the offering date price or the purchase date price, whichever is lowest and therefore best for you as the buyer.
There’s no reportable tax event when a qualified ESPP purchases shares on your behalf. However, you do create a taxable event once you sell these shares. The type of tax you need to report and how much you owe depends on a few key factors, including:
- The timeline between the offering date, the purchase date, and the sale date of your shares
- The discount received
- The purchase price and the sale price of the stock.
You may need to claim ordinary income and capital gains (or losses) when you sell your shares. Because so much depends on each individual situation, you may be best served by speaking with a financial advisor and CPA with experience in helping clients managing equity compensation so you know precisely how much you may owe.
How You’re Taxed When You Sell Restricted Stock Units (RSUs)
If you receive restricted stock units (RSUs) as part of your equity compensation, nothing is taxable until your shares vest. Once vested, the total value of the RSUs is subject to being taxed at your ordinary income rate.
Many employers automatically withhold 22% of the value of RSUs once they vest to help employees manage this tax burden. This withholding will cover some or all of the taxes you owe from your vested RSUs, although you may owe more depending on your income tax bracket.
The remaining value of the RSUs will typically be given to you as shares of stock that are deposited into an investment account. The shares often have a cost basis that is equal to the share price when the RSUs vested.
Once RSUs vest, the shares you receive look and act like shares that were purchased outright. If the shares are sold within a year, short-term capital gain/loss tax rules apply. If you hold the shares for longer than a year, the shares will qualify for long-term capital gains/losses when you eventually sell.
Understanding Taxes on Non-Qualified Stock Options
Restricted stock units limit your control over when you can recognize income from them and therefore when you owe taxes, because they’re subject to a vesting schedule. Non-qualified stock options (NQSOs), on the other hand, give you more control over triggering a taxable event.
NQSOs are issued with an exercise price, or the cost of buying the shares. If the current share price of the stock exceeds the exercise price, the stock option is “in-the-money.” If the current share price of the stock is less than the exercise price, it may not make sense to exercise the option and you don’t have to do so.
Your NQSOs become taxable when you exercise them. The spread between the exercise price and the fair market value at exercise is the amount subject to ordinary income and payroll taxes.
Using an example to illustrate, assume your company grants you 1,000 NQSOs with an exercise price of $5. Three years later, the market price of the stock is $50. If you exercised your options at that point, you’d need to claim the following as ordinary income on your tax return:
Ordinary Income = Number of Shares Exercised x (Fair Market Value at Exercise – Exercise Price)
1,000 x ($50 – $5)
Non-qualified stock options can be attractive because there is some control regarding what calendar year the income is recognized. Should you be a high-income tax year, it may make sense to not exercise because it could push your taxable income even higher. Exercising in a lower-income year can make more sense if it saves you on taxes.
If you hold your shares after you exercise your NQSOs, the cost basis of the stock is commonly equal to the fair market value at exercise. Like RSUs that are retained post-vesting, stock you own after exercising looks like shares that were purchased outright.
The Taxes You May Owe on Incentive Stock Options (ISO)
Incentive stock options are often the most challenging in terms of income recognition and subsequent taxation. The taxes you owe can be subject to the timelines between when ISOs are granted, exercised, and sold. The type of tax you’ll owe can vary, too.
With ISOs, you may need to pay ordinary income tax, capital gains tax, the alternative minimum tax (AMT), and potentially other types of taxes as well.
While incentive stock options can present added complications when compared to other types of equity compensation, they also provide some tax opportunities. If you exercise your ISOs according to certain rules, you could secure a lower tax rate on what you owe.
To have your liquidation of shares received from ISOs qualify for long-term capital gains tax rates (rather than ordinary income tax rates), you will need to need to meet the following criteria:
- The final sale of stock occurs at least two years past the grant date, AND
- At least one year past the exercise date of the option.
Doing so provides you with a qualifying disposition. But if you do exercise and hold shares from your ISOs for one year to achieve this, you may then need to pay the alternative minimum tax (AMT).
You can trigger owing AMT in the year you exercise your shares. The amount you owe is commonly based on the spread between the exercise price of the option and the fair market value when you exercise.
For more information about the alternative minimum tax, you may want to dive deeper into the topic here .
What Does This All Mean?
If you want to strategically liquidate company stock you received through some kind of equity compensation, you need to consider exactly what type of equity you have, where the shares came from, and what the tax implications for your actions may be.
A good strategy to unwind concentrated equity will likely consider both short- and long-term tax implications, current financial conditions, future financial expectations, all the available holding positions, and a shareholder’s overall investment goals and objectives.
*Asset allocation or diversification do not guarantee a profit or protect against loss.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts
The above hypothetical examples are for illustrative purposes only and do not attempt to predict actual results of any particular investment.